Central banks' 'forward guidance' proving a tricky policy tool

The European Central Bank (ECB) President Mario Draghi addresses a news conference at the ECB headquarters in Frankfurt, Germany, January 21, 2016. REUTERS/Kai Pfaffenbach

After first wowing markets at his March 10 news conference with a bigger-than-expected easing package, the European Central Bank president then muddled the message with a seemingly offhand remark that rates may have bottomed out.

Markets eventually calmed, but the reaction to his comment was the latest illustration of how central banks’ communications, in particular “forward guidance”, can go wrong, and explains why some are already backing away from this relatively new tool.

Central banks have long depended on communication to guide or warn markets: note former Federal Reserve Chairman Alan Greenspan’s warning about “irrational exuberance” to express caution about the dot-com bubble or Draghi’s promise in 2012 to do “whatever it takes” to preserve the euro.

But forward guidance can be an especially powerful tool because it signals policy intent, sometimes years into the future, reassuring or warning households and corporations about the future path of interest rates.

The result is a nuanced form of communication that can have an immediate positive effect on markets but also easily lead to more confusion than clarity and possibly misfire altogether.

“It’s not a promise, it’s a best guess. It can’t be too detailed and it can’t be a promise. In the worst case it can be confusing,” said Anatoli Annenkov, an economist at Societe Generale.

For the ECB, the difficulty around last week’s meeting may also signal bigger issues with managing expectations, several insiders told Reuters.

After more than a year of relatively short intervals between stimulus packages, continuous action has come to be seen as the norm at the ECB, placing the burden on the bank to avoid disappointment.

“Every time the Governing Council meets, the thinking is: what are we going to do next? Monetary policy can’t be this interventionist permanently... we need to communicate this better,” a source familiar with the bank’s thinking said.

Draghi won credibility at the height of the sovereign crisis with his bold promise to preserve the euro. But his problems are very different now, with the ECB bending over backwards to lift prices and ward off deflation.

The bank needs to better communicate that it is flexible about how much time is needed to get inflation back to its target, a source at one of the euro area’s 19 central banks said.

“Resolving some shocks takes longer than others and we need to highlight that the time component within the inflation target is not absolute but depends on the inflation shock.”

FREIGHT TRAIN

Widely used only since the financial crisis, forward guidance has been seen as a way to influence market expectations without implementing actual policies, especially at a time when conventional tools are nearly exhausted.

Developed more than a decade ago in places like Sweden and New Zealand, forward guidance can either publicly commit to future action -- or inaction -- or predict economic performance and a likely monetary policy reaction at a specific time.

But when the reality turns out differently, banks often have to backtrack, eroding their credibility.

Bank of England Governor Mark Carney, a champion of forward guidance, essentially abandoned the tool this year after previous steers were knocked off course by the plunge in oil prices and inflation, earning him the epithet of “an unreliable boyfriend” from a member of parliament.

First, he linked the possibility of a rate hike to the jobless rate, only to see the labor market recover much more strongly than expected, forcing the BoE to bin that strategy.

He then raised the prospect of a rate hike in 2014 and 2015, but the global economy has slowed and British wage growth remains stubbornly slow. Financial markets are currently pricing in no increase in borrowing costs until next year.

In January, Carney merely promised to “do the right thing at the right time” on interest rates.

The Fed has also pulled back from making explicit forward guidance after previously signaled rate hikes were delayed. It now insists that moves are “data dependent”, allowing it more flexibility.

Traces of forward guidance remain, however, in the so-called “dot plot” published every three months which shows in a graph what individual Fed board members and presidents project will be the expected path of rate hikes over time.

The Fed’s last dot plot suggested four hikes this year but markets expect just one at most, leaving a huge gap between projections and expectations, even if the Fed changes the plot at its meeting this week.

“What’s worrying me is that ... it (the dot plot) looks like a commitment, it looks like a freight train,” St. Louis Fed President James Bullard said recently.

Fed Governor Jerome Powell defended the inclusion of dates in the plot, given that the Fed expects rates to “only gradually” return to pre-crisis levels.

“Try saying that without referring to time,” Powell said.

The reality that central banks face is that with increased financial market volatility from commodities, an emerging market slowdown, deflation and bank balance sheet worries, looking too far into the future is becoming difficult and prone to policy reversals.

Societe Generale’s Annenkov said forward guidance is still a valid tool, however.

“It’s an additional communication measure, if you don’t overdo it with overly specific links to variables,” he said.

Additional reporting by David Chance in Washington, William Schomberg in London and Leika Kihara in Tokyo; Editing by Sonya Hepinstall